bankruptcy, reorganization, and liquidationleeds-faculty.colorado.edu/donchez/mbac 6060... · web...

Chapter 24Bankruptcy, Reorganization, and Liquidation

ANSWERS TO END-OF-CHAPTER QUESTIONS

24-1 a. Informal debt restructuring is the agreement between the creditors and troubled firm to change the existing debt terms. An extension postpones the required payment date, while a composition is a reduction in creditor claims. Extension provides payment in full, though delayed. Conversely, composition involves a reduced cash settlement. Restructuring often involves both extension and composition. A reorganization in bankruptcy is a court-approved attempt to keep a company alive by changing its capital structure. A reorganization must adhere to the standards of fairness and feasibility.

b. Assignment is an informal procedure for liquidating debts which transfers title to a debtor's assets to a third person, known as an assignee or trustee. Assignment normally yields creditors a larger amount than they would receive in a formal bankruptcy. However, an assignment does not automatically result in a full and legal discharge of all the debtor's liabilities, nor does it protect the creditors against fraud. Liquidation is the sale of the assets of a firm and the distribution of the proceeds to the creditors and owners in a specific priority. The decision whether to reorganize or liquidate should be based on the value of the firm if it is rehabilitated versus the value of the assets if they are sold off individually. The procedure that promises higher returns to the creditors and owners would be adopted. The standard of fairness states that claims must be recognized in the order of their legal and contractual priority. In simpler terms, the reorganization must be fair to all parties. The standard of feasibility states that there must be a reasonably high probability of successful rehabilitation and profitable future operations.

c. The absolute priority doctrine states that claims must be paid in strict accordance with the priority of each claim, regardless of the consequence to other claimants. The relative priority doctrine is more flexible and gives a more balanced consideration to all claimants than does the absolute priority doctrine.

Answers and Solutions: 24-1© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

d. The Bankruptcy Reform Act of 1978 was enacted to speed up and streamline bankruptcy proceedings. This law represents a shift to a relative priority doctrine of creditors' claims. Chapter 11 of the Bankruptcy Act is the business reorganization chapter. Under this chapter, a case is started when a firm's management or its creditors file a petition with the bankruptcy court. A committee of unsecured creditors is then appointed by the court to negotiate with the firm's management. Existing management may stay in office unless a trustee is appointed by the court. If no fair and feasible reorganization can be worked out, the firm will be liquidated under the procedures spelled out in Chapter 7 of the act. Chapter 7 of the Federal Bankruptcy Reform Act accomplishes three important tasks during a liquidation: (1) it provides safeguards against fraud by the debtor, (2) it provides for an equitable distribution of the debtor's assets among the creditors, and (3) it allows insolvent debtors to discharge all their obligations and to start new businesses unhampered by a burden of prior debt.

e. The priority of claims in liquidation is established in Chapter 7 of the Bankruptcy Act to provide an equitable distribution of the debtor's assets among the creditors.

f. Extension and composition are both characteristics of debt restructuring. In an extension, creditors postpone the dates of required interest or principal payments, or both. In a composition, creditors voluntarily reduce their fixed claims on the debtor by accepting a lower principal amount, reducing the interest rate on the debt, accepting equity in place of debt, or some combination of these changes. Workouts are voluntary reorganization plans arranged between creditors and generally sound companies experiencing temporary financial difficulties. Workouts typically require some restructuring of the old firm's debt. Cramdowns are bankruptcy court-mandated reorganization plans which are binding on all parties. Prepackaged bankruptcy is a new type of reorganization which combines the advantages of informal workouts and formal Chapter 11 reorganization. Holdout is a problematic characteristic of informal reorganizations where all of the involved parties do not agree to the voluntary plan. Holdouts are usually made by creditors in an effort to receive full payment on claims.


24-2 The rehabilitation plan may be accepted because of the following:

Expenses of liquidation may consume a large proportion of the assets.

The going-concern value of a firm is always substantially greater than its liquidating value. Hence, to preserve the life of the firm is to preserve a substantial portion of its value.

They may retain a stable customer for the future.

On balance, the creditors will accept a plan for financial rehabilitation because it appears that the funds they will receive will be much larger under this procedure.

24-3 Not necessarily. The going-concern value of a firm is a function of its outlook--it might be improved by changing the management or otherwise improving operations. The firm may be temporarily distressed.

24-4 Liquidations usually result in losses for the following reasons:

Assets typically have characteristics which make their value in existing uses greater than when resold.

The organizational value of a company is lost when liquidation takes place.

Because the claims of numerous parties must be adjudicated, considerable administrative, accounting, and legal costs may be incurred.

Partial liquidation over a period would have the following results:

Probably would not decrease losses.

Failure to institute the necessary operating and management changes might cause losses to continue and might cause further deterioration in the value of the company. It is often said that a swift major "surgery" for a business firm is preferred to an extended illness.

24-5 Because public utilities and railroads often involve essential services, reorganizations and mergers rather than liquidations are likely to take place. This is less true for industrial companies.


SOLUTIONS TO END-OF-CHAPTER PROBLEMS

24-1 Distribution of proceeds on liquidation:1. Proceeds from sale of assets $2,500,0002. First mortgage, paid from sale of assets 03. Fees and expenses of administration of bankruptcy 281,2504. Wages due workers earned within 3 months

prior to filing of bankruptcy petition 05. Taxes 06. Unfunded pension liabilities 0 281,2507. Available to general creditors $2,218,750

Distribution to general creditors:

Claims of General Creditors

Claim (1)

Application of 100%

Distribution(2)

After Subordination Adjustment

(3)

Percentage of Original Claims

Received(4)

Notes payable $ 750,000 $ 750,000 $ 750,000 100%Accounts payable 375,000 375,000 375,000 100Subordinated debentures 750,000 750,000 750,000 100

$1,875,000 $1,875,000 $1,875,000

The remaining $2,218,750 – $1,875,000 = $343,750 will go to the common stockholders. They will receive only $343,750/$1,875,000 = 18.33% of the amount of equity on the balance sheet.


24-2 a. The pro forma balance sheet follows (in millions of dollars):

Current assets $159a Current liabilities $ 42Net fixed assets 153 Advance payments 78Goodwill 15 Reserves 6

Subordinated debentures 90b

$2.40 preferred stock, $37.50 par value (1,200,000 shares) 45c

Common stock, $1.50 par value (6,000,000 shares) 9

Retained earnings 57Total assets $327 Total claims $327

Notes:a$168 less $9 used to retire the $10.50 preferred stock.b(1.2 million shares)($75 par value) = $90.c(1.2 million shares)($37.50 par value) = $45.

b. The pro forma income statement (in millions of dollars) follows:

Net sales $540.0Operating expense 516.0 Net operating income $ 24.0Other income 3.0 EBIT $ 27.0Interest expense 7.2a

Pre-tax earnings $ 19.8Taxes (50%) 9.9 Net income $ 9.9Dividends on $2.40 preferred 2.9b

Income available to common stockholders $ 7.0

Notes:a0.08($90 million par value) = $7.2.b$2.40(1.2 million shares) = $2.9.

Thus, the increase in income available to common shareholders is $7.0 - $5.7 = $1.3 million.


c. The earnings required before the recapitalization is $7.8 million/(1 - 0.5) = $15.6 million. We divide the preferred dividends by (1 - T) since $15.6 million must be earned to provide the $7.8 million needed after-tax. After recapitalization, the firm requires $2.9 million/0.5 = $5.8 million to cover the preferred dividend payment, and $7.2 million to cover the interest expense for a total of $13.0 million. Since interest expense is tax deductible, only $7.2 million in pre-tax earnings are required to cover the interest expense. Thus, required earnings will decrease by $15.6 million - $13.0 million = $2.6 million if the reorganization takes place.

d. The debt ratio before reorganization is $120 million/$336 million = 0.357 = 35.7%. After reorganization the debt ratio is $210 million/$327 million = 0.642 = 64.2%. Note that advance payments by customers are counted as debt while reserves are not. If preferred stock is treated as debt, the debt ratio actually declines slightly from 78.6 percent to 78.0 percent. The reorganization is in the best interests of the shareholders because under reorganization (1) earnings to shareholders are increased, (2) earnings required to cover fixed charges (including preferred dividends) are decreased, and (3) income debentures are less risky to the shareholders than preferred stock.

24-3 a. Creditor claims total $1,100,000 while the trustee has an additional $50,000 in claims, yet the liquidation produced only $600,000 in proceeds. Since the proceeds are insufficient to satisfy the creditor and trustee claims, the shareholders receive nothing.

b. The mortgage bondholders have priority claim against the proceeds from the sale of pledged property. Thus, the $400,000 from the fixed assets must first be distributed to the first and second mortgage bondholders. The first mortgage holders receive their full claim of $300,000, while the second mortgage holders receive the remaining $100,000. This constitutes the total $400,000, so none of the proceeds from the sale of pledged assets are available for distribution to general creditors. Additionally, the second mortgage holders have $100,000 in unsatisfied claims which become general creditor claims.

c. The priority claimants are the mortgage bondholders, trustee, workers, and government. The remaining claimants are general creditors. There is $200,000 available after the $400,000 distribution to the mortgage bondholders. This is distributed to the remaining priority claimants as follows:

Claimant AmountTrustee's expenses $ 50,000Workers' wages due 30,000Governments' taxes due 40,000Total $120,000


d. Of the total $600,000 received from the liquidation, $520,000 has been distributed to priority claimants. This leaves $80,000 to distribute to the general creditors. But the general creditor claims total $630,000:

Account ClaimAccounts payable $ 50,000Notes payable 180,000Second mortgage bonds 100,000Debentures 200,000Subordinated debentures 100,000Total $630,000

Note that the second mortgage holders' unsatisfied claim of $100,000 is included. Each claimant, before subordination adjustment, would receive $80,000/$630,000 = 0.1270 of his or her claim. Therefore, the general creditors would receive:

Account Amount ReceivedAccounts payable $ 6,350Notes payable 22,860Second mortgage bonds 12,700 (plus $100,000)Debentures 25,400Subordinated debentures 12,700Total $ 80,000

Finally, the subordination adjustment must be made. The subordinated debentures are subordinate to notes payable. Therefore, the subordinate debenture holders must relinquish all claims until the note payable holders are fully satisfied. Since the note payable holders are $180,000 - $22,860 = $157,140 short of being fully satisfied, the full $12,700 initially allocated to the subordinated debenture holders must be relinquished to the notes payable holders resulting in $22,860 + $12,700 = $35,560 for the notes payable holders and nothing (of the general creditor portion) for the subordinate debenture holders.


24-4 a. The total amount available for distribution is $3,190,000 proceeds + $10,000 cash = $3,200,000. The total creditor and trustee claims are $6,800,000 + $200,000 = $7,000,000. Since the claims far exceed the available funds, preferred and common stockholders will receive nothing.

b. The following table shows the liquidation distribution (in thousands of dollars):

Priority Creditor Subordination Claimant Distribution Distribution Adjustment PercentageAccounts payable $ 384 $ 384 24%Notes payable 120 500 100Wages payable $ 150 150 150 100Taxes payable 50 50 50 100Mortgage bonds 1,600 1,696 1,696 85Subordinated Debentures 600 220 9Trustee 200 200 200 100

$2,000 $3,200 $3,200

Funds remaining after the priority distribution = $3,200 - $2,000 = $1,200.

General creditor claims total $1,600 + $500 + $400 + $2,500 = $5,000.

After the general creditor distribution, notes payable is $500 - $120 = $380 short. Therefore, subordinated debentures must give up $380, leaving $600 - $380 = $220.


SOLUTION TO SPREADSHEET PROBLEM

24-5 The detailed solution for the spreadsheet problem, Ch24 P05Build a Model Solution.xls, is available on the textbook’s Web site.


MINI CASE

Kimberly MacKenzie, president of Kim's Clothes Inc., a medium-sized manufacturer of women's casual clothing, is worried. Her firm has been selling clothes to Russ Brothers department store for more than ten years, and she has never experienced any problems in collecting payment for the merchandise sold. Currently, Russ Brothers owes Kim's Clothes $65,000 for spring sportswear that was delivered to the store just two weeks ago. Kim's concern was brought about by an article that appeared in yesterday's Wall Street Journal that indicated that Russ Brothers was having serious financial problems. Further, the article stated that Russ Brothers' management was considering filing for reorganization, or even liquidation, with a federal bankruptcy court.

Kim's immediate concern was whether or not her firm would collect its receivables if Russ Brothers went bankrupt. In pondering the situation, Kim also realized that she knew nothing about the process that firms go through when they encounter severe financial distress. To learn more about bankruptcy, reorganization, and liquidation, Kim asked Ron Mitchell, the firm's chief financial officer, to prepare a briefing on the subject for the entire board of directors. In turn, Ron asked you, a newly hired financial analyst, to do the groundwork for the briefing by answering the following questions:

a. 1. What are the major causes of business failure?

Answer: The major causes of business failure consist of economic factors, such as industry weakness and poor location, and financial factors, such as too much debt and insufficient capital. However, most business failures occur because a number of factors combine to make the business unsustainable.

a. 2. Do business failures occur evenly over time?

Answer: A fairly large number of businesses fail each year, but the number in any one year has never been a large percentage of the total business population. The failure rate of businesses, however, has tended to fluctuate with the state of the economy.

a. 3. Which size of firm, large or small, is more prone to business failure? Why?

Answer: Bankruptcy is more frequent among smaller firms. While bankruptcy does occur in large firms, they tend to get more help from external sources to avoid it, given their greater impact on the economy and, in the case of large financial institutions, the financial world. The federal government's bailouts of Chrysler and Lockheed are good examples of this external assistance.

Mini Case: 24 - 10© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

b. What key issues must managers face in the financial distress process?

Answer: As a manager begins to face financial distress, he or she must begin to consider the following key issues:

Is this a temporary cash flow problem (technical insolvency), or is it a permanent problem caused by asset values having fallen below debt obligations (insolvency in bankruptcy)?

Who should bear the losses if this is a permanent problem?

Would the firm be more valuable if it continued to operate or if it were liquidated and sold off in pieces?

Should the firm file for bankruptcy, or should it try to use informal procedures?

Who should control the firm during liquidation or reorganization?

Obviously, answers to these questions are needed to chart the course of the firm while under financial distress.

c. What informal remedies are available to firms in financial distress? In answering this question, define the following terms: (1) workout, (2) restructuring, (3) extension, (4) composition, (5) assignment, and (6) assignee (trustee).

Answer: When faced with financial distress, it is often desirable for firms to pursue informal reorganizations or liquidations with creditors, given the costs associated with legal bankruptcy. Creditors generally prefer informal reorganization plans when dealing with economically sound companies whose financial difficulties appear to be temporary. These voluntary informal plans, commonly called workouts, tend to involve some type of restructuring, where current debt terms are revised to facilitate the firm's ability to make payments. Such restructurings typically involve extension and/or composition. In an extension, creditors postpone the dates of required interest or principal payments, or both. Creditors tend to prefer extensions when developing reorganization plans because they promise eventual payment in full. In a composition, creditors voluntarily reduce their fixed claims on the debtor by either accepting a lower principal amount or accepting equity in place of debt. This can be a desirable alternative if bankruptcy becomes a real possibility, since composition can help the creditor and debtor avoid the many costs associated with legal bankruptcy.


Informal liquidations can also be used if it is decided that the firm is worth more by selling it off in pieces. Assignment is an informal procedure for liquidating a firm. It calls for title to the debtor's assets to be transferred to a third party, known as the assignee or trustee. The assignee is required to liquidate the firm's assets either through a private sale or a public auction, and then to distribute the proceeds among the firm's creditors on a pro rata basis.

d. Briefly describe U.S. Bankruptcy Law, including the following terms: (1) chapter 11, (2) chapter 7, (3) trustee, (4) voluntary bankruptcy, and (5) involuntary bankruptcy.

Answer: U. S. Bankruptcy laws were first enacted in 1898 to ensure that businesses worth more as ongoing concerns were not shut down by individual creditors desiring liquidation and full payment. The Bankruptcy Reform Act Of 1978 revised these laws to streamline and expedite bankruptcy proceedings. Current bankruptcy law consists of eight chapters, the most important of which are Chapter 7, which details the procedures to be followed when liquidating a company, and Chapter 11, the business reorganization chapter. When a petition for bankruptcy is filed in federal court, the petition can be either voluntary or involuntary. A voluntary petition is filed by the distressed firm's management; an involuntary petition is filed by its creditors. The court will appoint a committee of unsecured creditors to negotiate a reorganization, which may include restructuring. A trustee will be appointed if current management is incompetent or fraud is suspected; otherwise the existing management will retain control. If no fair and feasible reorganization can be worked out, then the firm will be liquidated under Chapter 7 procedures.


e. What are the major differences between an informal reorganization and reorganization in bankruptcy? In answering this question, be sure to discuss the following items: (1) common pool problem, (2) holdout problem, (3) automatic stay, (4) cramdown, and (5) fraudulent conveyance.

Answer: There are many differences between voluntary reorganizations and reorganizations in bankruptcy. Voluntary reorganizations are far less costly and relatively simple to create as compared to reorganizations in bankruptcy. As a result, voluntary reorganizations typically allow creditors to recover more money, and sooner, than they would under legal bankruptcy. However, reorganizations in bankruptcy have their advantages. First, they avoid holdout problems which can arise with voluntary reorganizations (which occur when all creditors do not agree to the voluntary plan). Second, because of the automatic stay provision, bankruptcy avoids the common pool problem, where efforts to foreclose on the firm by one creditor cause the remaining creditors to initiate foreclosure as well. Automatic stay, which is granted to all firms in bankruptcy, limits creditors' abilities to foreclose unilaterally on the firm to collect their claims. Third, under bankruptcy, interest and principal payments may be delayed without penalty until a reorganization plan is approved. Fourth, bankruptcy permits the firm to issue debtor in possession (dip) financing to enhance the ability of the firm to borrow funds for short-term liquidity purposes. Finally, bankruptcy gives the debtor exclusive right to submit a proposed reorganization plan for agreement from the parties affected.

While bankruptcy gives the firm a chance to work out its problems without the threat of creditor foreclosure, it does not give the debtor free reign over the firm's assets. First, bankruptcy law gives creditors the right to petition the bankruptcy court to block almost any action the firm might take while in bankruptcy. Second, fraudulent conveyance statutes, which are part of debtor-creditor law in most states, protect creditors from unjustified transfers of property by a firm in financial distress.

In bankruptcy, it is much easier to gain acceptance of a reorganization plan, because the bankruptcy court will lump the creditors into classes. Each class is considered to have accepted a reorganization plan if a majority of the creditors in the class (holding at least two-thirds of the amount of debt) vote for the plan, and the plan will be approved by the court if it is deemed to be "fair and equitable" to the dissenting parties. This procedure, in which the court mandates a reorganization plan in spite of dissent, is called a cramdown.


f. What is a prepackaged bankruptcy? Why have prepackaged bankruptcies become more popular in recent years?

Answer: Prepackaged bankruptcy is a relatively new type of reorganization which is a hybrid--combining the advantages of both the informal reorganization and formal Chapter 11 reorganization. The debtor obtains agreement from all, or almost all, creditors to a reorganization plan prior to filing for bankruptcy. The plan is then filed along with, or shortly after filing, the bankruptcy petition. This method can avoid the holdout problems of voluntary reorganizations, preserve creditors' claims, and provide favorable tax treatment.


g. Briefly describe the priority of claims in a Chapter 7 liquidation.

Answer: Chapter 7 of the federal bankruptcy reform act provides for an equitable distribution of the debtor's assets among the creditors. The distribution of assets is governed by the following priority of claims:

Secured creditors (who are entitled to the proceeds of the sale of specific property pledged for a lien or a mortgage).

Trustee's costs to administer and operate the bankrupt firm.

Expenses incurred after an involuntary case has begun but before a trustee has been appointed.

Wages due workers if earned within three months prior to filing of the petition in bankruptcy.

Claims for unpaid contributions to employee benefit plans that should have been paid within six months prior to filing.

Unsecured claims for customer deposits.

Taxes due to federal, state, county, and any other government agency.

Unfunded pension plan liabilities.

General, or unsecured, creditors.

Preferred stockholders.

Common stockholders.


h. Assume that Russ Brothers did indeed fail, and that it had the following balance sheet when it was liquidated (in millions of dollars):

Current assets $40.0 Accounts payable $10.0Net fixed assets 5.0 Notes payable (to banks) 5.0

Accrued wages 0.3Federal taxes 0.5State and local taxes 0.2 Current liabilities $16.0First mortgage $ 3.0Second mortgage 0.5Subordinated debenturesa 4.0 Total long-term debt $ 7.5Preferred stock 1.0Common stock 13.0Paid-in capital 2.0Retained earnings 5.5

Total equity $21.5Total assets $45.0 Total claims $45.0

Athe debentures are subordinated to the notes payable.

The liquidation sales resulted in the following proceeds:

From sale of current assets $14,000,000From sale of fixed assets 2,500,000Total receipts $16,500,000

For simplicity, assume that there were no trustee's fees or any other claims against the liquidation proceeds. Also, assume that the mortgage bonds are secured by the entire amount of fixed assets. What would each claimant receive from the liquidation distribution?


Answer: The following table shows the liquidation distribution (millions of dollars):Distribution to Priority Claimants

(in millions)

Proceeds from the sale of assets $16.5Less: 1. 1st mortgage (paid from sale of fixed assets) 2.5 2. Accrued wages 0.3 3. Taxes due to federal, state, and local governments 0.7Funds available for distribution to general creditors $13.0

Distribution to General Creditors

Distribution PercentageGen’l creditor Amt. Of pro rata after subord. Original claim claims claim distrib. 1 adjustment received

1st mortgage $ 0.5 $ 0.325 $ 0.32594%

2nd mortgage 0.5 0.325 0.32565

Notes payable 5.0 3.250 5.000100

Accts. Payable 10.0 6.500 6.50065

Subord. Deben.2 4 .0 2 .600 0 .850 21

Total $20 .0 $13 .000 $13 .000

Notes:

1. $13 million is available for distribution to general creditors; however, there is $20 million in general creditor claims, so the pro rata distribution will be $13/$20 = 0.65, or 65 cents on the dollar.

2. The debentures are subordinated to the notes payable. The amount of the unsatisfied notes payable is $5.0-$3.25=$1.75 million. $1.75 million is reallocated from the subordinated debentures to notes payable.


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